CAPITAL MARKETS CAPITAL MARKETS BSC/BBA III BSC/BBA III Winter Semester 2010 Winter Semester 2010 Lahore School of Economics Lahore School of Economics
Welcome message from author
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
CAPITAL MARKETSCAPITAL MARKETS
BSC/BBA IIIBSC/BBA IIIWinter Semester 2010Winter Semester 2010
Lahore School of EconomicsLahore School of Economics
Chapter 3Chapter 3
Depository InstitutionsDepository Institutions
Depository InstitutionsLearning Objectives
What is a depository institution?
How a DI generates income?
What is the Asset/Liability problem for DI’s?
What is Funding Risk?
What are DI’s funding sources?
What are Reserve Requirements?
Depository Institutions?
Include:
Depository Institutions?Include:
Institutions that take deposits
Deposits represent Liabilities (debt) for DI’s
Include:
Banks
Savings & Loan institutions
Credit Unions
How do DI’s make money?
3 ways:
How do DI’s make money?3 ways:
LoansMake direct loans to entities
Securities investmentsInvesting in securities & holding portfolios
FeesCharged to their customers
Importance of DI’s?
Heavily regulated because:
Importance of DI’s?
Heavily regulated because:
Their role in financial system
a) Creating the financial playing field
Principal means of making payments
a) Individuals & Businesses use for payments
Vehicle for Govt monetary policy
a) MP implemented through banking system
Special Privileges
Access to Federal Deposit Insurance
Provision of liquidity in emergencies
Govt has interest in DI’s stability & survival…
Asset-Liability Management 2 Main problems:
Funding Risk
Liquidity Risk
Asset-Liability Management
Funding Risk:Illustrate using 100MM, 7% 1 & 10 yrs
Use of Spreads (DI’s make money)
Difference between bid/ask or charging premiums
Gaps
Open positions created due to duration differences
Interest rate exposure
Funding activity resulting in interest rate risk
Asset-Liability Management
Opportunities:
Asset-Liability ManagementOpportunities:
Interest Rate view Managers who have expectations of interest rate
changes will seek to profit from funding!
If Interest rates rise
What position should you have?
If interest rates fall
What position should you have?
Asset-Liability ManagementOpportunities:
Interest Rate view Managers who have expectations of interest rate
changes will seek to profit from funding!
If Interest rates rise
DI will benefit if it has borrowed long & lent short because when interest rates will rise its cost will remain unchanged but will be able to lend at a higher rate!
If interest rates fall
DI will benefit if it has borrowed short & lent long!
Asset-Liability Management
Threats of positioning:
Asset-Liability Management Threats of positioning:
Adverse financial consequences
If expectations are not realized, Huge losses can occur
No one can predict interest rates consistently
Highly risky
Becomes same as gambling
Long run losses highly likely
Asset-Liability Management
Main goal of Mgmt:
Asset-Liability Management
Main goal of Mgmt:
Try Locking in the spread
Minimize interest rate exposure
Various financial instruments used to manage risk
Asset-Liability Management
Main goal of Mgmt:
Try Locking in the spread
(By not trying to bet on interest rate movements, focus should solely be on earning from the spread not on interest rate movements)
Minimize interest rate exposure
(By investing in assets & Liabilities of similar maturity ranges)
Various financial instruments used to manage risk
(Examples include interest rate options, swaps & forwards)
Liquidity Concerns of DI’s?
Balancing two activities?
Liquidity Concerns of DI’s?
Balancing two activities:
Satisfy Withdrawals of customers (Liquidity Concerns)
Liquidity required
Provide Loans to customers (Earnings)
Liquidity Concerns of DI’s?
4 ways to solve liquidity issues?
Liquidity Concerns of DI’s?
4 ways to solve liquidity issues:
Attract deposits
Borrowing from Federal Agency or other Financial Institutions (using security collateral)
Sell Securities on hand
Raise Funds in Money Markets
Liquidity Concerns of DI’s?
Increase Borrowing using securities:
Discount window borrowing at Fed
Liquidity Concerns of DI’s?
Sell securities it owns:
DI must invest in ST, liquid securities with little Price Risk and keep these in its inventory
E.g: stocks?... No, Bonds? …. No
Solution: ?
Liquidity Concerns of DI’s?
Sell securities it owns:
DI must invest in ST, liquid securities with little price risk and keep these in its inventory
E.g stocks?... No, Bonds? …. No
Solution: Short term, Money Market instruments like Treasury Bills, Commercial Papers etc
Liquidity Concerns of DI’s?
SECONDARY RESERVES?
Securities held by a DI for the purpose of satisfying withdrawals or loans.
Disadvantage?
Lower yield
% of assets as secondary reserves depends on DI’s risk/return appetite
Liquidity Concerns of DI’s?
One more reason for holding liquid assets?
Liquidity Concerns of DI’s?
One more reason for holding liquid assets?
To fulfill Govt regulation!
In form of Reserve Requirements (discussed later)
Commercial Banks
3 Main Types of services:
3 Main Types of services:
Individual Banking
Institutional Banking
Global Banking
Commercial Banks
Individual Banking
Consumer Lending
Residential Mortgage
Credit Card financing
Car & Boat Financing
Brokerage services
Student Loans
Commercial Banks
Institutional Banking:
Loans to Corporations
Loans to Insurance companies
Loans to Government
Commercial Financing & Leasing
Commercial Banks
Global Banking:
Foreign Exchange products
Capital Markets products
Corporate financing products
Commercial Banks
How do Banks raise Funds?
Commercial Banks
How do Banks raise Funds?
3 Main Sources of Funds
Deposits
Non-Deposit Borrowing
Common Stock & Retained Earnings
Commercial Banks
How do Banks raise Funds?
3 Main Sources of Funds
Deposits
(Demand Deposit, Savings Deposit, Time Deposits)
Non-Deposit Borrowing
(Borrowing from Federal Reserve through Discount window, Repurchase Agreements, borrowing by the issuance of instruments in the money & bond market)
Common Stock & Retained Earnings
Commercial Banks
Reserve Requirement &
Borrowing at the Fed Funds Market?
Banks must maintain a %age of deposits with Federal Reserve called Reserve Ratio.
The cash kept with Fed is called Required Reserve.
Commercial Banks
Reserve Requirement
Type of Deposits:
Transaction Deposits Non-transactions Deposits
Reserve Ratios are higher for transaction Deposits relative to non transaction deposits!
Reserve Requirements Reserve maintenance period
2 Week period where the average of the daily total of each type of deposit is taken to get RR (THR-WED)
Actual Reserves
Average Amount of Reserves held at the close of business at the Federal Reserve Bank during each day of a two week reserve maintenance period.
Excess Reserves
If bank reserves exceed the RR at the Fed
Fed Funds Market & Fed Funds
Banks short of RR borrow from Excess Reserves of other Banks at Fed Funds rate.
Fed Discount Window:
Fed is the Banker’s Bank – last resort
Charges DISCOUNT RATE
Collateral
Treasury securities, Govt securities etc.
Heavily Discourages its use
Will investigate if use becomes frequent
Reserve Requirements
Regulations
Regulation of Interest rates Geographical Restrictions Permissible Activities for Commercial
Banks Capital Requirements for Commercial
banks
Regulations Regulation of Interest rates
Ceilings imposed on the interest rate that can be paid on Deposit Accounts.
Geographical Restrictions
This legislation was intended to prevent large banks from expanding geographically & thereby taking over smaller banking entities, threatening competition.
Permissible Activities for Commercial Banks Capital Requirements for Commercial banks
Permissible Activities for Commercial Banks
The permissible activities of banks are limited to those that are viewed by the Fed as closely “related to banking”.
Banks can neither underwrite securities & stocks, nor can act as dealers in the secondary market.
Banking act of 1933 Prohibits any depository institution from engaging in the securities business.
Capital Requirements for Commercial Banks
The ratio of equity Capital to total assets is low, typically less than 8% in case of banks.
“Off Balance Sheet Obligations” Risk Based Capital Requirements
Risk Based Capital Requirements
Types of Capital Tier 1 Capital (Core Capital)
It consists basically of common Stockholder’s Equity, Preferred Stock & minority interest in subsidiaries. It is based on book Value of Total Assets.
Tier 2 Capital (Supplemental Capital)
It includes loan loss Reserves, Perpetual Debt & hybrid Capital Instruments. It is based on Risk Weighted Assets.
Risk Based Capital Requirements
Risk Weight
Examples of Assets included
0% U.S Treasury Securities, MBS issued by GNMA
20% Municipal general Obligation bonds, MBS issued by Govt. Associations
50% Municipal Revenue Bonds, Residential Mortgages
100% Commercial loans & mortgages, Corporate Bonds.
Risk Based Capital Requirements- Example
Asset Book Value (in millions)
US Treasury Securities 100
Municipal General Obligation Bonds
100
Residential Mortgages 500
Commercial Loans 300
Total Book Value 1000
Risk Based Capital Requirements- Example
Asset Book Value
Risk Weight
Product
US Treasury Security
100 0% 0
Municipal Bonds 100 20% 20
Residential Mortgages
500 50% 250
Commercial Loans 300 100% 300
Risk Weighted Assets
570
Risk Based Capital Requirements-Example Risk Weighted Assets = 570 million Minimum Core Capital Requirement (Tier 1)
= 4% of Total assets= 4% of $1000 million= $ 40 Million
Minimum Total Capital= 8% of Risk Weighted Assets= 8% of $570= $ 45.6 Million
Minimum Supplemental Capital Requirement (Tier 2)= 45.6 – 40= $5.6 Million
Depository Institutions
Summary
What is a depository institution?
How a DI generates income?
What is the Asset/Liability problem for DI’s?
What is Funding Risk?
What are DI’s funding sources?
What are Reserve Requirements?
Assignment # 1
Q1: The following is the book value of the assets of a bank:
Asset Book Value (in millions)
US Treasury Securities $50
MGBO 50
Residential Mortgages 400
Commercial Loans 200
Total Book Value 700
Assignment # 1
a) Calculate the risk weighted Assetsb) What is the minimal Core Capital Requirement?c) What is the minimum total Capital
Requirement?
Asset Risk Weights
US Treasury Securities 0%
MGBO 20%
Residential Mortgages 50%
Commercial Loans 100%
Assignment # 1Q2: What is meant by individual Banking?
Institutional Banking? Global Banking?Q3: Explain: Reserve Ratio, Required
Reserves, Excess Reserves.Q4: Are higher or lower interest rates
beneficial to institutions that borrow short & lend long? Explain!
Thank you for your Time & Patience
Related Documents
